Portfolio Diversification

Diversification by portfolio is time tested and statistically valid method of managing risk, since in every combination of investment some negative correlation and risk reduction takes place. Specifically, this means that even though each investment has its own risk profile, the winds of change that blow through the economic system will impact each investment in a different way. Therefore, when investments are combined the sum total of risk can be less that the sum of the individual risks. For example, gold, which is a tangible value, has historically increased in value in weak economic times, while stocks and other intangible values are dropping in price. Thus an investment combination of gold and stock presumably provides a "hedge" against change and loss of overall value. Or to put it another way, an investment in a combination of gold and stock would appear to have less risk than a total commitment to either investment.

Thus all investment managers, including corporate financial officers, seek ways of combining investments which will prevent serious loss in many economic scenarios, including recession, high interest, inflation, etc. and are willing to pay the inevitable "price" for this protection. The price paid for protection through diversification is the reduced earnings that take place in that portion of the portfolio being negatively impacted in any scenario. In other words when paper values such as stocks are rising rapidly, that portion of the portfolio invested in gold is not doing as well, and therefore weighs against the overall value.

Several mathematical formulas have been developed to measure combinations of investment for risk reduction purposes. The time tested classics are those centered around covariance analysis where the year by year experience of two investments is measured to determine whether, based on every economic scenario, they are positively or negatively covaried. A high positive covariance would indicate a reduction in risk from combining them, while a negative relationship in their results would indicate positive risk reduction possibilities. A more advanced mathematical process called correlation coefficient analysis, will calculate the degree of risk reduction achieved by various combinations.

Other techniques to evaluate the risk (and thus the price) of adding an investment to a diverse portfolio have also been developed in recent years. One of these, the Capital Asset Pricing Model, (CAPM), is widely used to determine the risk of a single investment, not as a stand alone, but as a risk which of added, may negatively impact the diversified portfolio of investments one already owns and should, therefore, be priced not by an evaluation of its stand alone risk, but on the basis of its impact on the portfolio to which it will be added.

In this type of analysis the question is not, What is the risk of this investment? Rather, it is, How will this investment react with the rest of my investment portfolio? Sometimes, an investment that would not be selected because of its stand alone risk will make an ideal negatively correlated risk for other investments being held because it will provide the necessary hedge against loss.

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